LBW INSIGHTS

At the end of the first quarter (“Q1”) of every year, it begins to feel like spring (well sometimes not in WI), bringing great memories. One of my (Tim’s) favorites: the anticipation of knowing that the Salt Lake City Firefighters’ annual Lagoon day was around the corner. It was almost time to go ride the best roller coaster in UT, the Colossus[1]. I would constantly think about getting in the cart and going up the first hill, hearing click, click, click, until finally it was no more. And then boom – flying down the hill, zipping around corners, going around, not just one, but two full loops! It was a kid’s dream. Now, I may not be able to go ride the Colossus this year, but the markets in Q1 stepped in and took its place. For example, from the beginning of Q1 to its peak, the S&P 500 gained roughly 7.45%[2] (the hill). And from its peak to trough[3], it dropped -10.16%[4] (the drop), which, by definition, is a correction[5]. By the end of the quarter, the S&P 500 gained back roughly 8.93%[6] (the loops) of what it had lost and ended the quarter down -1.22%[7] (the finish).

So far, the volatility of the markets has moved as fast and as quick as my beloved roller coaster, a far cry from what we witnessed in 2017. Its twists and turns were so intense that rumblings began to surface that we may be entering the next recession. As we all know, markets move as new information is brought to light, moving up with perceived good news and down with perceived bad. And Q1 didn’t disappoint in the news department.

The momentum from Q4 2017 continued into Q1 riding high off the news of the newly cemented tax reform – “Tax Cuts and Jobs Act of 2017”. The markets continued to rally as pundits felt the tax reform would increase the bottom line of most American companies. For example, Berkshire Hathaway released its 2017 year-end results announcing its company’s net worth increased by $65.3 billion[8]. CEO Warren Buffet had this to say to his shareholders: “The $65 billion gain is nonetheless real – rest assured of that. But only $36 billion came from Berkshire’s operations. The remaining $29 billion was delivered to us in December when Congress rewrote the U.S. Tax Code.”[9] Combine tax reform with a strong beginning of the Q1 earnings season and you began finding yourself climbing a big hill, just like the Colossus.

Friday, February 2nd, 2018 was the day when the clicking noise stopped and we began our descent. The odd part – the news that day was positive. The Bureau of Labor Statistics released January’s employment and wage growth, and unemployment figures – all three exceeded expectations. In fact, average hourly earnings rose by 0.3%, increasing the yearly average to 2.9%, which was the highest level since June 2009[10]. Unemployment stayed steady at 4.1% and 200,000 jobs – 20,000 more than analysts expected – were created in the month of January. The problem – sometimes with economics, good news is bad news. The markets looked at this and began to evaluate how these positive numbers could impact inflation, interest rates, and the growth of the economy. The following Monday, eyes were fixated on newly appointed Fed Chair Jerome Powell and the path moving forward for the Federal Reserve. Questions like “How fast will the Fed increase interest rates?” or “Are we at the peak of this historical bull market?” surfaced and the markets began to fall further. That day[11] the S&P 500 dropped -4.10%, totaling a two day drop of -6.22%. On Thursday, February 8th, 2018 we hit the bottom of the hill. The S&P 500 dropped by -3.75%, once again the thought of the economy improving meant inflation was going to increase and the country would have to begin weaning itself off artificially low interest rates and intense monetary measures.

As we started accelerating to the loops and the dust settled, the markets gained as we technically corrected and companies’ earnings were strong. The markets were thrown back into a frenzy as the Trump administration and China trade talks began to intensify. Unlike the positive economic data, as the discussion began to go further into the depths, the markets began to waver in their optimism. If the proposed tariffs were to go through, pundits felt it would slow down growth both domestically and globally. Once again, fresh news threw the markets back and forth as the future of trade and economic growth became increasingly uncertain.

As one can see, the markets truly did match my childhood roller coaster – the only difference: actual roller coasters are more fun. The gyrations in the markets were intense and we are beginning to glide closer to the peak of economic expansion and most people recognize this. It comes down to the same old question “Are we in the 7th or 9th inning?”, but the reality is no one knows. The only thing truly known is that market cycles are healthy and expected. As inflation increases and the Fed begins to pump the breaks on monetary easing, our economy will begin to tighten. If the economy begins to tighten, it could affect the overall growth and potentially throw us into what is considered a recession[12]. Add in the current geopolitical risks, and the slowdown in economic growth could accelerate. This thought process is not our way of predicting the next downturn, but it does beg the question on where returns will head over the next ten years. The last decade has produced exceptional returns and moving forward we feel similar returns will be harder to achieve. Volatility in the markets can be your friend. As we state in almost every commentary, we are aware of macro factors, we just don’t allow them to dictate how we invest. We attempt to mitigate this risk by performing thorough research, having a long-term investment horizon, and understanding what we own and pairing with others who do the same. We will continue to watch out for opportunities, and when they present themselves, we will be ready to pounce.

Nathaniel's Beautiful Mind

​Mutual Fund SpotlightThe GoodHaven Fund started operations in 2011. Its co-founders, Larry Pitkowsky and Keith Trauner, met one another at Fairholme Capital Management (FCM) when they first started working there in the same year (1999). They both left FCM in 2008, and after their applicable non-competes ended, they launched GoodHaven. These two are not only incredibly open with their line of thinking regarding their portfolio holdings, but also with exploring their mistakes. Their portfolio holdings have been in sectors such as oil & gas exploration & production, metals & mining, diversified holding, tech, and financials. I’m comfortable with companies in some of these areas, but certainly not all. We know that Larry and Keith have in-depth knowledge of their holdings and are not only comfortable with enormous bouts of volatility but love to take advantage of volatility when it occurs. These are exactly the kind of managers that we feel comfortable placing our client’s money with.

My Thoughts on CommerceHub being Bought OutFor this quarter’s writeup, I wanted to give you a peak under the hood of what I think about when making a portfolio management decision. To do this, I’m going to discuss the buyout of CommerceHub[13] (CHUBA/K), why I’m not pleased with the proposed transaction, and why I ultimately decided to sell out of the position.

Before we jump to our opinions of the transaction, a little background on CommerceHub and the transaction. On March 6, 2018, CommerceHub announced they were being taken private by two private equity firms, GTCR and Sycamore Partners for $22.75 per share in cash. The expected closing date of the transaction will be in 2018 Q3. CommerceHub’s price immediately rose to the $22.30-$22.50 mark across all its respective share classes. A little history: CommerceHub was spun off from Liberty Ventures (LVNTA) on July 22, 2016. For our clients who have been with us for a while, you may remember us writing about the former tracker stock[14] LVNTA’s exchangeable debentures and it being controlled by one of our favorite capital allocators, John Malone. Because of the spinoff, Malone maintained voting control of CommerceHub.

CommerceHub is a SaaS company acting as a middleman and drop-shipper for Retailers like Walmart or Target to connect to Brands/Suppliers like Nike or Samsonite, and Delivery services like UPS or FedEx, while offering Marketing and Social Media services to all three of these categories, all via one connection. If a big retailer like Walmart decides to come on board, they will typically require their suppliers to come onto the platform as well. These suppliers will then connect to CommerceHub, and Walmart will essentially have virtual inventory. That is, Walmart will be able to observe their suppliers’ inventories in real-time, which allows Walmart to not only be more efficient with real-time data, but to also lower their working capital requirements by not having to have as much inventory on hand. With Walmart now able to see this virtual inventory, Walmart can now do something called drop-shipping. Drop-shipping is when a Walmart customer orders a pair of Nike shoes via Walmart.com, and the order is shipped directly from Nike’s warehouse, but is then white-labeled to appear as if it came from Walmart.com. CommerceHub typically charges a subscriber fee to maintain a connection to their platform, and then a usage fee for all inventory that flows through their platform. As more retailers come onto CommerceHub’s platform and more suppliers follow the retailers, CommerceHub’s network effect will grow. As their network effect grows, their moat grows increasingly stronger.

As one can imagine due to CommerceHub’s moat, the company’s economics were quite enticing. Here’s what I liked about CommerceHub:

It didn’t matter if Revenue growth wasn’t increasing at some crazy exponential growth rate because its Free Cash Flow (FCF) was growing at a 25+% IRR[15]

2017’s Return on Invested Capital was astounding at 75+%, and had grown at a 30+% IRR[16]

CommerceHub had net debt of ~$34.9M starting in 2016 Q2, and by 2017 Q4 had paid it down and had a net cash balance of ~$19.8M. That’s a $54.7M swing in 1.5 years.

Most investors would be rejoicing – we’re not. Here’s what I don’t like about the transaction:

Not a great price for shareholders: I believe the proposed offering price undervalues CommerceHub by approximately 10-15% if I use 2017’s ending FCF of $35.5M

Opportunity Cost: I estimated that CommerceHub’s FCF could grow ~20+% for the next 10 years. If bought at the right price, of which there were many opportunities to do so throughout its short tenure as a publicly-traded company, a shareholder would likely reap high returns on their investment. Now, if CommerceHub is taken private, our clients will miss out on owning such a great company. Upon the transaction’s completion, I now must find a similar if not better idea selling at a good price to compensate for CommerceHub being taken off the table. I can tell you that especially right now, such opportunities are very hard to find.

Now we get to the portfolio management reasoning behind the sale of our client’s shares. The aforementioned notwithstanding, I had a decision to make regarding whether I sell now or hold till the transaction’s proposed closing date (2018 Q3). As I saw it, once the transaction was announced, it was in our clients’ best interests to sell their CHUBA and/or CHUBK shares. Below is my thought process:

The transaction doesn’t go through: for whatever reason, the deal falls through. The share price falls, perhaps to the price range I’m willing to buy at, and I buy back shares for our clients. In the off chance I haven’t sold the shares yet, this is a possible means to make amends if the price goes into my buyable range. In addition, our clients maintain ownership in a compounder.

The transaction goes through at the proposed price of $22.75 per share: as the stock was trading in the 22.30-22.50 range, it didn’t make sense to hold on for another ~6 months till the transaction closed, simply to get an extra 1-2% return. The proceeds of the sale could be utilized as dry powder when an opportunity came knocking.[17]

Another suitor comes in and offers a higher price: based on my calculations, CommerceHub’s buyout price was undervalued by ~10-15%. Hence, we could miss out on a potential 10-18% increase from the $22.75 offer price. However, this was not a hostile bid as the company actively put itself out there as a potential buyout target. This scenario’s odds were low in my opinion.

I also took into consideration short-term versus long-term capital gains. As many of our clients know, we like to say that “we’re tax-aware, not tax-efficient”. I went through all our clients’ accounts that held CHUBA and CHUBK to see if I could get our clients’ gains into long-term capital gains’ rates territory. Here are the statistics:

All CHUBA shares had been purchased before this date, and therefore were already in long-term capital gains’ rate territory. 42.2% of our clients’ CommerceHub shares were CHUBK shares and had been purchased after July 1, 2017, and 26.9% after October 1, 2017.

Of that 42%, the average cost basis per share for CHUBK was $18.15.

CHUBK’s closing price the day before the announcement (March 5, 2018) was $17.47.

Assume a conservative sale price of $22.30, and earliest estimated closing date of July 1, 2018 (first day of 2018 Q3).

Conservatively assume that all clients are in the highest marginal tax bracket of 37% for short-term capital gains’ rate and subject to a 20% long-term capital gains’ rate only (for purposes of this example, let’s assume the 3.8% Medicare surtax does not apply).

Here’s what I found: Even if I waited till the transaction closed sometime in 2018 Q3, 26.9% would be almost guaranteed to have short-term capital gains and 15.3% would possibly be subject. Assuming that 15.3% could be subject to long-term capital gains, let’s compare the difference between selling in early March versus waiting till the transaction closed. If I sold post-transaction announcement in early March at a conservative sale price of $22.30 and had an average cost basis per share of $18.15, the gross cumulative return would be 22.9% ([$22.30-18.15]/$18.15) and short-term capital gains would subtract 8.5% (22.9%*37%), leaving a net return of 14.4% (22.9%-8.5%). If I were to wait till closing, the gross cumulative return would be 25.3% ([$22.75-18.15]/$18.15) and long-term capital gains would subtract 5.1% (25.3%*20%), leaving a net return of 20.3% (25.3%-5.1%). I then measured the difference between the net return had I sold in early March of 14.4% versus transaction close of 20.3% to be 5.9%. I compared this -5.9% difference in return, applicable only to the 15.3% of shares that would possibly be subject to long-term capital gains, to what would happen if the transaction terminated. I assumed that the price would fall from $22.30 to the $17.47 price it closed at before the announcement, which would equal a gross return of -21.7% ([$17.47-22.30]/$22.30). I compared the potential -5.9% return difference versus the possible loss of -21.7% and decided it was well worth the risk to sell now versus waiting till the transaction’s close.

To sum up, CommerceHub was a good investment and we were disappointed to see it come off the table; however, the return generated in a short time frame was nice. My goal with this quarter’s commentary was to bring our clients into the trenches of both investment management and portfolio management. At times, the two can conflict and I do my best to ensure I make the best possible decisions on behalf of our clients, and CommerceHub happened to be a prime candidate at showcasing the difficult decisions I sometimes have to make. I believed that the transaction is likely to go through, and decided it was in our clients’ best interests to sell all their shares after the announcement even after considering the impact of short-term capital gains. Despite my reservations about the offer price and having to find another actionable idea as good as CommerceHub, it was ultimately the best decision for our clients. I hope you enjoyed this dive into “Nathaniel’s Beautiful Mind”.